Financial Crisis, Effective Policy Rules and Bounded Rationality in a New Keynesian Framework

This paper extends a standard open-economy New Keynesian model to examine the efficiency of alternative monetary policy rules (both fixed and nonlinear) during a period of financial crisis. A third-generation “balance sheet effect” is made operational through an endogenous risk premium which impacts on investment. Special attention is given to alternative expectations structures and our findings under both rational expectations and adaptive learning establish the Taylor rule as the dominant policy. Moreover, under adaptive learning, we find additional policy traction and less instrument variability in rules augmented with the exchange rate. Building on the nonlinear policy rule framework, we illustrate the debate stemming from the Asian crisis regarding the prescription of monetary policy in the presence of liability dollarization. Interestingly, under rational expectations, “Traditionalist” (or IMF-prescribed) policy is most effective at mitigating exchange rate variability, while “Revisionist” policy is most effective at mitigating real output variability. All rules in this study, however, advocate a sharp initial interest rate response to the crisis.